An Empirical Investigation of Firms' Responses to Minimum Standards Regulations

We study firms' responses to minimum standards and other forms of regulatory intervention on both the probability of exit and the distribution of observable product quality, using firm level data for a nationally representative sample of markets. Our empirical work is motivated by the literature on quality and price competition in the presence of minimum standards. We find that minimum standards increase the probability that firms exit certain markets. Moreover, we find that exit can cause both the average and the maximum quality observed in the market to decline. This perverse regulatory effect occurs when excessively high standards cause high quality firms to exit. When minimum standards do not lead to exit, minimum standards can increase the average and maximum quality of products in the market. Such standards can not only force low quality firms to raise their quality, but may cause high quality firms to increase quality, presumably in an attempt to alleviate price competition and differentiate themselves from their now higher quality rivals.